October 15, 2009

Case Study: Financial Performance Measurement

Consistency of Other Corporate Objectives to Primary Financial Goal of
Maximizing Shareholder’s Wealth

Major user groups of financial statements (FS) include investors/ shareholders,
employees, lenders, suppliers, customers, government and the public. Basically,
investors and shareholders are concerned on income (from dividends) and gain
(from stocks price), employees on wage, salary and employment opportunities,
lenders on the resources of the firm (both cash and non-cash), suppliers on
financial stability of cash flow, customers on ability to supply quality goods,
government on performance for the purposes of taxation and the public on
employment, environmental and other social responsibility disclosures (2006).
In general, firms must comply with the FS needs of these stakeholders to concede
their legitimacy to exist in the society (1996).
Otherwise, the latter can implore aggressive or indirect actions (strikes,
pull-out of investments, litigation, etc.) that can ultimately lead to corporate
demise.

Listed or public companies are, more than anybody else, responsible
to these stakeholders and impart in protecting its legitimacy. This is because
they come full contact with the public, therefore, exposed their companies to
several and trickle-down effects on the public at large. As a result, other
than maximization of shareholder’s wealth, corporate finance is also intended to
aim objectives for other stakeholders. But the question is how they are
consistent with shareholder’s primary aim?

Poor
accounting feeds speculative beliefs which can lead to stock market bubbles and
inefficient markets that ultimately direct to damage economies ( 2003). This is
because even if entrepreneurs with poor business models can easily obtain cash
through hot IPO markets which in turn affect the chance of more productive firms
to ensure capital for more positive community impact. Further, the primary
reason of poor accounting is non-compliance with sound accounting practice
(2003) which can stem from management and accountants’ inability to separate
facts from forecasts (2005). This temptation is fueled with the need to sustain
shareholder confidence to the company as well as attract another set of
investors.

Such method
will hardly be prioritized and isolated by international standards (e.g.
International Financial Reporting Standards) because it is bias to
capital-providers and undermine the need of other stakeholders for efficient
allocation of resources. In effect, this lead to a conclusion that companies,
to be able to continue operations, should be initially compliant to the
requirements of its legal owners (e.g. shareholders) before it can serve other
stakeholders. Leniency of IFRS is necessary for companies to obtain
flexibility; otherwise, it would not be able to continue operations due to
shareholder dismay and may as well be unable to serve larger part of the
community.

Investor focus, however, is not always the case. For example,
employees and managers are considered as internal stakeholders. Listed
companies are bound to provide them with equitable compensation and maintain
their motivation during growth or recession. Such objective should not be
ignored due to the fact that human resources and capital is the most important
asset of the firm ( 2003). Consistency on the primary objective is observed
when internal stakeholders are strictly recruited, trained and continuously
motivated through certain reward systems. This would make the labor force more
productive and loyal that can reflect the long-term achievement of the
investor’s objective. However, the experience of General Motors wherein its
financial difficulty arose from implementation of retirement plans for its
employees showed the conflict between labor force and investor needs.

In what case
it may be, public communication through social responsibility disclosure is
necessary (2006). Even if the society as well as the legitimacy pressures
maintains a certain status quo for the whole year, organizations should comply
with social disclosures because this type of disclosure is never neutral but the
by-product of an “entity and society relationship”. In addition, legitimacy
theory is derived from system-based theories which mean that a firm can affects
its environment on top of the societal changes and its impacts to the firm. In
effect, activities that is thought to have, having or previously had impacted
the society and environment in both positive and negative manner should be
properly cited. Political economy framework also related the economic
activities of a firm to political, social and institutional environments stating
that economic issues are not are discernable (or profitable and strategic for
that matter) if these factors are undermined in corporate operations ( 2006).

Social
disclosure is a set of information firms used to comply with one of its
functions which is “to account for certain corporate actions” (2006). As
reporting is driven by responsibility rather than societal demand, the indirect
stakeholders also find their worth in social disclosures even if their
expectations are largely implicit. The managerial side of stakeholder theory
provides the identity and ultimately the strengths and weakness of annual
reports. Aside from the fact that ethical nature of stakeholder theory is
non-testable (therefore, no strict standards can be imposed to firms), listed
companies are responsible in emphasizing the social responsibilities of their
organizations. In effect, companies accomplish disclosures an integrated and
sufficient social responsibility reports as it reflect the managerial
capabilities and ethical considerations.

Gearing
Management as WACC Minimization Strategy

A firm’s
capital structure (CS) is usually a mix of financing alternatives (19992). To
understand the concept of CS, three basic financing terms should be considered.
According to (2006), debt financing is the act of providing capital by
selling bonds, bills or notes to individuals or institutions while common/
preferred stock is sold through equity financing. Taken in simpler terms, the
former refers to long-term borrowings while the latter refers to long-term funds
(). Lastly, debt/ equity ratio is equal to their quotient whose answer is used
as a measure of company’s financial leverage or gearing (2006). Optimal CS is
achieved when the firm’s cost of capital is minimized and its market value is
maximized (). However, this statement is approached conflictingly by two main
views.

In
traditional model, capital structure is related to the value of the company and
it assumes that the weighted average cost of capital (WACC) can be minimized
(Mcmenamin 1999). When WACC is minimized and the value of the firm is
maximized, it is said that optimal capital structure is available to the firm.
Figure 1 is a graph that shows the relation of gearing and cost of capital. The
optimal capital structure is at point m where the value of the firm is at its
highest level and financial risks are in its lowest level. When gearing, debt
is continuously injected in the capital structure of the firm where initially it
remains stable. However, as injection persists, at certain point, cost of debt
increases gradually. As debt increases, the financial risks of the firm also
increases as lenders demand higher returns caused by high gearing that the
company implements. These lenders see that the firm may have limited paying
capacity due to the bottleneck of debt.

Figure 1: The
Relationship of Cost of Capital and Gearing in Traditional View

Also in
figure 1, the cost of equity increases as financial gearing increases. This
direction relationship is caused by the traditional view that equity holders are
also exposed to financial risks because lenders have bigger priority over them
in case of business difficulties. Overall, the graph shows that WACC initially
falls due to introduction of lower cost debt but eventually begins to increase
after reaching a minimum point wherein the cost of equity and debt begin to
increase. These situations seemed to be possible due to the following
assumptions; namely, all earnings are distributed as dividends, earnings are
expected to remain constant indefinitely, all investors have identical
expectations about future earnings, taxation is ignored, business risk remains
constant and capital structure can be altered immediately by exchanging debt for
equity or equity to debt and transaction are free of cost.

On a
different view, Modigliani and Miller argued that cost of capital is not related
to capital structure or alternatively capital structure is independent of the
firm’s value (1999). Proposition 1 is explained using the pie model. The pie
model explains that two companies may have different capitals structure, say;
each has 75:25 and vice versa as their equity-to-debt ratio but the size of the
pie for each company remains the same at 100% level. The proposition only
merits earnings before interest and taxes (EBIT) and volatility of the EBIT as
reflection of the firm’s value. On the other hand, WACC is merely used to
capitalize the future earnings of the firm. However, proposition 1 assumes the
absence of arbitrage where traditional view’s assumption would take place. The
former assumes perfect markets and that pricing anomalies will not operate.
Thus, when gearing-up, proposition 1 is insensitive to the effects of
traditional view and the firm would be in the same footing or value geared or
un-geared.

Proposition 2
assumes that the expected yield on a share of stock is equal to capitalization
rate for purely equity stream and a premium that results in the difference of
financial risks of debt and equity (1999). Simply put, proposition 2 observes
financial risk premium or compensation for companies that are highly geared.
Figure 2 shows that cost of equity capital is a linear function of its capital
structure. The figure shows that when gearing is increased, it also tends to
increase the cost of equity or the required rate of return of shareholders.
However, even with this consequence, WACC remained unchanged as the trade-off
between debt and equity financing exist. For example, the advantages of
gearing-up are cheaper debt accessibility but this advantage is cancelled by
increasing cost of equity.

Figure 2: The
Relationship of Cost of Capital and Gearing in Modigliani and Miller

When rates are regulated, CS receives countervailing incentives based on a
primary guide in gearing, that is, “a firm wishes to signal high value to
capital markets to boost its market value while also signaling high cost to
regulators to induce rate increases” (Spiegel 1997 p. 1). When both high- and
low-cost firms are confronted with a large investment project, countervailing
incentives lead them to implement a financing strategy that hinders their CS
from private information. This situation makes their CS similar. On the other
hand, when investment is relatively small, high-cost firms prefer equity issues
while low-cost firms prefer debt issues.

There exists financing strategies available to the regulated firms in support of
the traditional model to gearing. Such strategies, however, relies on two
situations. First, the regulated firm must exploit the incentive to be highly
geared because regulators are deterred from lowering the rates (therefore,
minimizing the motivation of creditors to take its bonds) as it may lead to
bankruptcy of these firms (1997). Second, there should be asymmetrical
information that exists between the regulators, creditors and the regulated firm
about the firm’s costs which would alter the incentive to leverage. In effect,
as regulators are rate-setter, the strategies of the regulated firms are within
a game of regulatory commitment under asymmetric information.

The regulated firm is said to maximize two incentives in the game. One is to
signal low expected costs and high profits to the capital market to boost the
market value of its securities (1997). Another is that to convince regulators
that its expected costs are high to manipulate rates according to cost effect
(e.g. high costs = high rates). As observed, the regulated firm is capable and
would likely implement two-conflicting tactics to achieve its maximization goal
even though the means is to hide information between the capital market and
regulators. However, this tendency is limited only to big investment projects
because regulated firms cannot issue debt when engaged in smaller projects. In
effect, they cannot tap positive leverage effect. For example, those low cost
firms issue relatively little equity while high-cost firms have little to gain
in imitating the former. Alternatively, high-cost firms that issue high equity
are mimicked by low-cost firms giving the high-cost firms equity-under pricing
effect.

Further, if the project is large, the tendency of both low- and high-cost firms
is to finance it with wholly debt to exploit the leverage effect coupled with
the admission that they are low-cost firms to boost market value of their
securities (1997). However, the incentives (therefore, the traditional view)
are diluted in the long-run because the capital market cannot determine who
really are low-cost firms because everybody is claiming. Traditional view is
applicable when regulated firms act in certain manners. For example, they
initially issue debt up to a specific target, and then they mix equity in the
CS. This strategy is regarded as an alternative in asymmetric information
failure or emergence of market efficiency where regulated firms cannot validate
their respective incentives.